1 Regulation Fueling This High-Yield Sector

A new banking regulation is a boon for high-yield BDCs like Prospect Capital and Ares Capital and a bust for traditional commercial bankers.

Feb 24, 2014 at 3:09PM
Uncle

These days, regulators have become the banks' worst enemy. From multibillion-dollar settlements to the Consumer Financial Protection Bureau and Basel III rules, banking is more regulated than ever.

Luckily, a more aggressive regulatory environment is only helping non-bank lenders gain lending volume, market share, and profits.

High-yield stocks getting a lift
Few investors have heard of business development companies. The industry lends to small companies, generally to finance buyouts by private equity investors, and pay massive dividends of 10% or more per year. The biggest players are Ares Capital (NASDAQ:ARCC) and Prospect Capital (NASDAQ:PSEC), two companies with combined balance sheets topping $13 billion.

Historically, BDCs had to compete with banks to find new borrowers. The industry was especially competitive given that the average loan would price with interest rates topping 10% per year. The pricing is because of the risk -- these are loans with little collateral, with the business' future profits expected to back loan payments. Ares Capital and Prospect Capital provide "cash flow loans," based on a businesses' cash flows, not its existing assets like real estate or accounts receivables.

How banks were pushed out
The Office of the Comptroller of Currency issued a note that details how banks can participate in leveraged loans. The new guidelines will put increased scrutiny on banks that lend at multiples greater than six times EBITDA. For example, a business with earnings before interest, taxes, depreciation, and amortization of $100 million could not be financed by a bank if it were to take on more than $600 million in debt.

How do these limitations match up with the industry? Poorly.

At six times EBITDA, an asset-light, service business would be valued at about 10 times earnings after taxes. And asset-light service-oriented businesses make up the bulk of middle-market borrowers -- they're borrowers that can actually afford to repay a loan priced with 10% interest paid in cash.

"Unfair" rules are great for BDCs
If there is one word to describe the guidelines from the OCC and the Federal Reserve, it's unfair. The reason is simple: New limits on leveraged lending are completely arbitrary.

Whereas six times EBITDA might be far too much debt for an oil company that has inherently high capital expenditures, it's a tiny multiple for a cash-generating, capital-light business like a software company. The rules, however, make no distinction between "good" borrower and "bad" borrower. All borrowers levered at more than six times EBITDA are, in effect, "bad" borrowers.

Luckily, the regulatory environment doesn't extend to non-bank lenders like business development companies. Ares Capital and Prospect Capital are free to lend to any company they want, at any multiple they wish. Thus, a deal at 6.5 times EBITDA may be out of reach for traditional banks, but fits squarely in the portfolio of Ares Capital or Prospect Capital. 

The Foolish bottom line
Regulatory changes from the OCC and Federal Reserve will have the greatest impact on the largest BDCs that directly compete with commercial banks for deals -- larger BDCs like Prospect Capital and Ares Capital. Over time, this should lead to better-quality borrowers turning to non-banks, while limited competition will only drive loan pricing higher. It's good for non-banks, bad for the banks. 

The dirty secret of dividend stocks
One of the dirty secrets few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend-paying brethren. The reasons for this are too numerous to list here, but you can rest assured it's true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top analysts put together a free list of nine high-yielding stocks that should be in every income investor's portfolio. To learn the identity of these stocks instantly and for free, all you have to do is click here now.

Jordan Wathen has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers